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Optimal Monetary Policy and Portfolio Choice

Author

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  • Sebastian Fanelli

    (MIT)

Abstract

A recent and rapidly increasing literature has documented the presence of sizeable cross-currency mismatches in countries' balance sheets. Yet, existing studies of optimal monetary policy focus on economies with either a single bond or complete markets. We bridge this gap by studying a small open economy with nominal rigidities where home agents are able to borrow abroad in both home- and foreign-currency bonds. In this environment, monetary policy faces a trade-off between providing insurance and doing inflation-targeting. To solve the optimal policy problem, we develop a technique to approximate the solution around the deterministic steady state with locally incomplete markets. When home-currency-bond markets are perfect, the central bank commits to a smooth exchange rate to induce agents to be significantly exposed to currency risk, giving monetary policy firepower to create wealth transfers at low cost. In contrast, if markets are imperfect and agents cannot choose such large positions, a volatile exchange rate is the only way to provide insurance. Finally, we show that despite the presence of aggregate demand externalities, private portfolio choice decisions are efficient in the approximated model.

Suggested Citation

  • Sebastian Fanelli, 2017. "Optimal Monetary Policy and Portfolio Choice," 2017 Meeting Papers 1586, Society for Economic Dynamics.
    • Handle: RePEc:red:sed017:1586
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    References listed on IDEAS

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    1. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
    2. Bénétrix, Agustin S. & Lane, Philip R. & Shambaugh, Jay C., 2015. "International currency exposures, valuation effects and the global financial crisis," Journal of International Economics, Elsevier, vol. 96(S1), pages 98-109.
    3. Jesse Schreger & Wenxin Du, 2014. "Sovereign Risk, Currency Risk, and Corporate Balance Sheets," Working Paper 209056, Harvard University OpenScholar.
    4. Kollmann, Robert, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," Journal of International Economics, Elsevier, vol. 55(2), pages 243-262, December.
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    Cited by:

    1. Aquino, Juan Carlos, 2018. "The Valuation Channel of External Adjustment in Small Open Economies," Working Papers 2018-011, Banco Central de Reserva del Perú.

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